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The Evolution of U.S. Energy Dominance and Its Potential Effects on Exchange Rates

By Frances Coppola

The U.S. government has stated a strategic aim for the country to become globally dominant in energy production, by which it means not just self-sufficiency but "complete energy security" and "global leadership and …influence."1 To this end, it is encouraging large increases in U.S. production of energy sources, particularly oil and natural gas. Evaluating the impact of this strategy on commodity prices and currency exchange rates may help international businesses plan for what could be a major shift in global trade dynamics, as well as the value of the dollar.

This article is first in a series looking at how energy markets have developed since World War II, and how today's global energy market trends may influence exchange rates. It lays the foundation for understanding how U.S. energy dominance may affect businesses today.

 

How the U.S. Lost Control of Oil Prices and USD's Exchange Rate

 

The U.S. was dominant in energy production during the 1950s and 1960s. At that time, the U.S., as the world's largest oil producer, effectively controlled the global price of oil by managing output so as to maintain stable low prices.2 The fact that the U.S. dollar was pegged to gold under the Bretton Woods system of managed exchange rates also helped to keep oil prices stable.

 

The formation of the Organization of Petroleum Exporting Countries (OPEC) in 1960 as a competitor to the "Seven Sisters" cartel of Anglo-American oil producing companies marked the beginning of the end of U.S. oil dominance.3 OPEC's production steadily grew throughout the 1960s, along with its membership.4 By 1970, OPEC was producing 55 percent of the world's oil. At the same time, Texas oilfields reached peak production, effectively ending the U.S.'s ability to control global oil supply by managing its own output. As a result, the U.S. was forced to cede control of oil prices to OPEC.5 OPEC has effectively controlled the oil price by restricting supply ever since, though this is being eroded by increasing output from non-OPEC oil producers such as Russia.6

 

Concurrently with OPEC's rise, the growing cost of the Vietnam war and rising domestic inflation put downward pressure on the U.S. dollar's peg to gold. In 1971, President Nixon suspended USD convertibility to gold,7 triggering a period of severe exchange rate instability which resulted in the collapse of the Bretton Woods managed exchange rate system.8

 

In 1973, a war in the Middle East disrupted global oil supplies, which raised the price of oil to (then) unprecedented levels.9 This triggered a sharp rise in U.S. inflation and put severe downward pressure on the dollar's exchange rate.

 

The Birth of the Petrodollar

 

After the 1973 oil price shock, stabilizing the Middle East and gaining effective control of oil reserves became a top priority for the U.S. There followed a series of bilateral deals between the U.S. and Saudi Arabia, in which the U.S. offered military support in return for Saudi Arabia invoicing oil in USD. In 1975, Saudi Arabia persuaded the rest of OPEC to invoice oil sales in USD.10 U.S. dollars earned through the sale of oil became known as "petrodollars."11

 

This confirmed the U.S. dollar as the primary international reserve currency. Creating a link between the dollar and the oil price effectively replaced the peg to gold and helped to stabilize the dollar's exchange rate. That USD-oil link also ensured that there would always be international demand for the dollar, helping to prevent speculative attacks on the currency.12

 

Since then, OPEC countries with USD revenues from oil sales have "recycled" those dollars into purchases of USD-denominated assets, particularly U.S. Treasury bonds. The circular flow of dollars from the U.S. to oil-producing countries via oil sales, and back to the U.S. via asset purchases, is known as "petrodollar recycling."13

 

Petrodollar recycling has helped to keep the dollar's exchange rate stable and the U.S.'s borrowing costs low. In this way, it has helped to protect the U.S. economy from oil price swings. Further, because pricing oil (and, today, other energy sources) in USD creates high demand for dollars from the rest of the world so that they can spend those dollars on the energy they need, it has helped the U.S. to run large fiscal and trade deficits without fear of a buyer's strike or a run on the currency.14

 

The U.S. no longer dominates energy markets by controlling the supply of oil. But petrodollar recycling maintains a kind of U.S. energy dominance because the U.S. controls supply of the currency the world needs to buy and sell oil and other energy sources.

 

The

Takeaway:

As oil production by other countries increased, U.S. dominance of the global energy market changed from controlling the supply of oil to controlling the supply of U.S. dollars, the currency in which oil and all globally traded energy sources are priced. The second piece in this series examines how the potential rise of a "petroeuro" and the increasing importance of non-oil energy sources and non-OPEC production threatens the petrodollar's dominance – and, therefore, the stability of the dollar's exchange rate.

Frances Coppola - The Author

The Author

Frances Coppola

With 17 years’ experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.

Sources

1. “US forges ahead on oil and gas exports pledge,” Financial Times; https://www.ft.com/content/41818388-164f-11e8-9e9c-25c814761640
2. “Oil Price History and Dynamics,” WTRG Economics; http://www.wtrg.com/prices.htm
3. “What are the Seven Sisters oil companies?,” Herold’s Financial Dictionary; https://www.financial-dictionary.info/terms/seven-sisters-oil-companies/
4. “1960s Oil Production,” The History of Global Oil Production; https://sites.google.com/site/globaloilproduction12/1960-s-oil-production
5. “Oil Price History and Dynamics,” ibid.
6. “The Millennium and Present-Day Production,” The History of Global Oil Production; https://sites.google.com/site/globaloilproduction12/the-millennium-and-present-day-production
7. “The Nixon Shock,” Treasury Today; http://treasurytoday.com/2011/09/the-nixon-shock
8. “1973: The End of Bretton Woods,” Deutsche Bundesbank; https://www.bundesbank.de/Redaktion/EN/Topics/2013/2013_10_14_end_of_bretton_woods.html
9. “1970s Oil Production,” The History of Global Oil Production; https://sites.google.com/site/globaloilproduction12/1970-s-oil-production
10. “The Future of the Dollar in the Middle East/Persian Gulf,” Momani; http://www.arts.uwaterloo.ca/~bmomani/Documents/NPE_GCC_Oil_Exporters.pdf
11. “How Petrodollars Affect the US Dollar,” Investopedia; https://www.investopedia.com/articles/forex/072915/how-petrodollars-affect-us-dollar.asp
12. “The Future of the Dollar in the Middle East/Persian Gulf,” Momani; http://www.arts.uwaterloo.ca/~bmomani/Documents/NPE_GCC_Oil_Exporters.pdf
13. “How Petrodollars Affect the US Dollar,” Investopedia; https://www.investopedia.com/articles/forex/072915/how-petrodollars-affect-us-dollar.asp
14. The Future of the Dollar in the Middle East/Persian Gulf,” Momani; http://www.arts.uwaterloo.ca/~bmomani/Documents/NPE_GCC_Oil_Exporters.pdf

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